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CHAPTER 15: MONETARY POLICY

The Central Bank’s Balance Sheet

The central bank conducts the monetary policy of the country.


Assets and Liabilities of the central bank:
 ASSETS
Securities (bonds)
Purchased from commercial banks (and public).
Forms part of public debt.
Bought and sold to influence reserves of comm banks

Loans to comm banks

 LIABILITIES
Reserves of comm banks
Comm banks must hold a certain % of their deposits as reserves at the CB

Treasury Deposits
The National Treasury keeps deposits at the CB. (the government’s bank is
CB)
The money comes from taxes, selling bonds, borrowings.

 SARB NOTES OUTSTANDING


Notes circulating outside SARB.
It is a claim against the assets of SARB

** Tools of Monetary Policy

1. Open-Market Operations

~Buying and selling of government bonds from SARB, comm banks and public

Buying Securities (bonds)


SARB wants to buy bonds:

From Comm Banks:


Comm banks have bonds that they are giving to SARB
SARB pays by increasing the comm banks’ reserves account
Comm banks have more reserves ⇒ they can loan more
⇒ money supply increases

From the Public:


Some members of the public have bonds they are willing to sell to SARB
Public gets a cheque and deposits it into a comm bank
Comm bank deposits the additional reserves created into SARB. Comm bank
can loan out more by the increase in excess reserves
⇒ Money supply increases.
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To Read: there is no difference in the amount of impact on money supply, fig 15.1

Selling Securities (bonds)

To Comm Banks:
SARB sells bonds to comm banks
Comm banks pay for bonds by decreasing their reserves (they draw cheques that
↓ their deposits)
Fewer loans can be available
⇒ Money supply decreases

To the Public
SARB sells to public
Public pays by cheque drawn from comm bank
Deposits ↓ ⇒ reserves ↓
⇒ Money supply decreases

To Read: no difference in the amount of the impact on money supply

Example 1:
Suppose that SARB buys R5000 in government bonds.
The reserve ratio is 10%.
What is the net impact of the money supply if the bonds are bought by commercial
banks only?

A:
 Money multiplier = 1/0.1 = 10
 Comm banks have additional R5000 in excess reserves
 Max deposit creation
= 5000 × 10
= 50 000

Money supply increases by R50 000

Example 2:
Suppose now that the bonds are bought from the public.
a) What is the new change in the comm banks excess reserves?
b) Calculate the change in money supply

A:
a) Banks receive R5000 in deposits from the public.
They require 0.1 × 5000 = R500 in required reserves.
They have 5000 -500 = R4500 in excess reserves.

b) R4500 loaned out ⇒ 4500 × 10 = R45 000 created.


Public still has R5 000 in deposits
⇒ Money supply has increased by
R45 000 + R5000
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= R50 000

2. Reserve Ratio

Raising the Reserve Ratio

Recall: Reserve ratio is the % of deposits comm must hold as reserves

SARB increases the reserve ratio


Required reserves are increased
Excess reserves decrease, or reserves not enough
⇒deposits must decrease
Bank can let loans mature and not extend new credit or it can sell bonds.
Amount of loans available decreases
⇒ Money supply decreases

Decreasing the Reserve Ratio

SARB decreases the reserve ratio


Required reserves are decreased
Excess reserves increase,
Amount of loans available increase

⇒ Money supply increases

Example 3
SARB changes the reserve ratio from 10% to 15%.
What is the change in money supply if comm banks have R10 000 in deposits, R 20
000 in actual reserves? Assume: comm. banks are using all of their excess reserves to
provide loans.

A: Initially:
Required reserves:
10 000 × 0.1
=R1000

Excess Reserves
= 20 000 – 1000
= R19 000

Money Supply= excess reserves × multiplier


=19 000 × 10 = 190 000

Change in reserve ratio:


Required reserves:
= 10 000 × 0.15
= R 1 500 ( > R1000)
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Excess Reserves:
= 20 000 – 1 500
=R18 500

Money supply = 18 500 × 6.67


= 123 333

Change in Money supply = 190 000-123 333 = 66 667 (decrease in MS)

3. Discount (repo) Rate

SARB charges the repo rate for loans given to comm banks.
Comm banks borrow from SARB

⇒ banks’ reserves increase.

Increase in discount rate

cost of borrowing increases because the comm bank has to pay more for the
loan
Comm banks take out fewer loans from SARB
Comm banks receive less additional reserves
Loan out less
⇒ Money supply decreases

Decrease in discount rate

cost of borrowing decreases because the comm bank has to pay less for the loan
Comm banks take out more loans from SARB
Comm banks receive more additional reserves
Loan out more

⇒ Money supply increases

Example 4:
Suppose the Bank A can pay R500 for its initial installment to SARB. This amounts to
a loan of R6250 from SARB at the repo rate of 8%.
SARB now increases the repo rate to 8.5%. What loan can Bank A afford at the same
payment of R500?

A:
x × 0.085 = 500
500
x=
0.085
= R5882.35 (< R6250)

Bank A can only afford a lower amount than before.


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**Easy (Expansionary) Monetary Policy


In time of slow growth or recession SARB can do the following to increase the money
supply:
 Buy securities
 Decrease the reserve ratio
 Decrease the discount rate

**Tight (Contractionary or Restrictive) Monetary Policy

In time of too much spending and too high increases in inflation rate SARB can do the
following:
 Sell securities
 Increase the reserve ratio
 Increase the discount rate

Q: What is the preferred tool of SARB to control money supply in SA?

Monetary Policy, Real GDP, Price level

Q: How does Monetary Policy affect the economy???

Exercise 1
SARB has decided to buy bond from comm banks and the public:
a) What type of monetary policy is this?
b) Explain how buying of bonds will affect the money supply?
c) How does aggregate supply change?
d) What is the resultant change in GDP and the price level?

Money Market

• Money demand is inversely related to the real interest rate (why?)


⇒ negatively sloped
• Money supply is vertical
• Equilibrium at intersection of money demand and money supply curves.

Sm

i0

Dm

M0 Money
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Investment

• Investment demand inversely related to the real interest rate (why?)

Q: Distinguish between interest rate of purchasing capital goods vs the interest


rate on buying bonds.

i0

I0 I

Equilibrium GDP

• AD positively related to investment

• Equilibrium at intersection of AD and AS curves

P AS
AD

P0

GDP
Q0
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Effects of an Easy Money Policy

 The economy is below full employment


 SARB uses its tools for Monetary policy to increase money supply
 Money supply curve shifts right
 Money supply increases from M0 to M1
 The real interest rate decreases from i0 to i1

S0 S1

i0

i1

Dm

Money
M0 M1

 As a result of the decrease in the real interest rate, Investment increases


 Investment increases from I0 to I1

i0

i1

I
I0 I1
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 An increase in Investment causes AD to increase

 AD shifts to the right

 Equilibrium is at a higher GDP

 Price level stays the same or rises depending on where the economy
was before the change.

P
AS

P1

P0
AD1

AD0

Q1
Q0 GDP

Effects of a Tight Money Policy

Problem: High inflation

SARB uses tight monetary policy via tools:


→ Excess reserves decrease
→ Money supply decreases (shifts left)
→ Interest rate increases
→ Investment decreases
→ AD decreases (shifts left/down)
→ GDP and Price level decreases

Exercise 1: Draw the relevant curves to show the impact of GDP caused by a tight
monetary policy application.
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Monetary policy in action

The most popular tool being used is the repo (discount) rate
Read: The Focus on the Fed Fund Rate

Problems and Complications

 Lags
It takes a while to recognize what the economic changes are (recession or
inflation increasing/decreasing)
Once SARB acts on the findings, it takes time for the impacts to spread
through the economy.
e.g. SARB increases the repo rate but investment only decreases after a few
months.

 Changes in Velocity
Velocity: the number of times a rand is spent on goods and services in the
economy per year
Higher velocities tend to increase inflation

Spending (Expenditure) = money supply × velocity of money

Example 5
If money supply is R25 000 and velocity of money is 5, what is the expenditure?
A: expenditure = 25 000 × 5
= R125 000

Problem: Velocity can move opposite to the changes in the money supply – making
the monetary policy less effective.

Eg. A tight monetary policy restricts the money supply, but velocity may increase.
Inflation does not decrease to the level as expected.

This problem occurs because of the asset demand for money.


An easy money policy may decrease the interest rate but at a lower rate:
⇒ people hold more money and do not transact as much
⇒velocity decreases
⇒opposite effects to easy policy

 Cyclical Asymmetry
Monetary policy can be more effective in controlling inflation and slowing
expansion but is not as effective for an easy money policy.

The most recent target is inflation targeting.


SARB makes sure that inflation is between the 3 – 6% range.

Read: Artful management or Inflation targeting?


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Monetary Policy and the International Economy


We were dealing with a closed economy, now we add the international community

Net Export Effects

Easy Monetary Policy


→ Decrease in the interest rate
→ Decrease in the foreign demand for rands
→ Rand depreciates
→ Net exports increase
→ AD increases
⇒ easy monetary policy is strengthened

Tight Monetary Policy


→ Increase in the interest rate
→ Increase in the foreign demand for rands
→ Rand appreciates
→ Net exports decrease
→ AD decreases
⇒ tight monetary policy is strengthened

Macro stability and trade balance


Trade balance: balance exports to imports
Suppose that SA is in a trade deficit: imports > exports:

Easy Monetary Policy


Decrease in the interest rate
→ Decrease in the foreign demand for rands
→ Rand depreciates
→ Net exports increase
→ AD increases AND exports increase until trade deficit reduced
⇒ easy monetary policy corrects the trade deficit and brings SA back to trade balance.

Tight Monetary Policy


Increase in the interest rate
→ Increase in the foreign demand for rands
→ Rand appreciates
→ Net exports decrease
→ Trade deficit decreases
⇒ Tight monetary policy has made the trade deficit worse than before.

Suppose SA has a trade surplus:

An Easy Monetary Policy makes the trade surplus higher.


A Tight Monetary Policy reduces the trade surplus bringing back to a trade balance.

*** Go over Fig 15.4 for summary of all effects**